Understand Financial Statements
There is a perception that financial statements are complex and can only be interpreted by professional accountants. On the contrary, once you become familiar with the overall concepts and the terminology used, you will have an appreciation for the valuable information they contain and will understand how to apply your knowledge to evaluate the business.
What are Financial Statements
Financial statements consist primarily of the balance sheet and an income statement. An explanation follows:
The Statement of Financial Position (Balance Sheet)
The ‘Statement of Financial Position’ reports a company's financial status at a set date noted on the statement. The statement is like a snapshot because it shows what the company is worth at that set date. The statement shows:
- What the company owns
- What the company owes
- What belongs to the owners
The ‘Statement of Financial Position’ is also referred to as the ‘Balance Sheet’ because of the way one part — assets — is in balance with the sum of the other two parts – liabilities and stockholders' equity. In other words, the amount of money invested in the business, plus the amount that has been borrowed by the business, must equal the assets.
When the owner of the business is an individual, net worth is usually referred to as ‘owner’s equity; however, when dealing with a corporation there can be several shareholders so net worth is referred to as ‘shareholders’ equity’. Annual financial statements normally include information for at least the last two years to allow comparison of changes between years.
The balance sheet shows three main categories of information for each year:
- Shareholder’s Equity
The things that a company owns are called assets. These things might be physical assets such as buildings, trucks, inventory, equipment, and cash. Or they might intangible assets such as goodwill, trademarks, and patents.
Assets are either current or non-current (fixed assets). Current assets include cash, government securities, marketable securities, accounts receivable, notes receivable (other than from officers or employees), inventories, prepaid expenses, and any other item that could be converted into cash within one year in the normal course of business.
Fixed assets are those assets acquired for long-term use in a business such as land, plant, equipment, machinery, leasehold improvements, furniture, fixtures, and any other items with an expected useful business life measured in years (as opposed to items that will wear out or be used up in less than one year and are usually expensed when they are purchased). These assets are typically not for resale and are recorded on the balance sheet at their net cost less accumulated depreciation.
Other Assets include intangible assets, such as patents, royalty arrangements, copyrights, exclusive use contracts, and notes receivable from officers and employees.
The amounts of fixed assets vary by company and industry. For example, manufacturing companies generally have a large investment in fixed assets because making things requires property, plant, and equipment. Service companies usually have fewer fixed assets.
On the balance sheet, debts are called liabilities. All companies have liabilities. Examples of liabilities include:
- Money owed to banks and other lenders
- Money owed to suppliers of goods and services (accounts payable)
- Taxes owed to government authorities
- Rents owed to owners of land and buildings
Liabilities are either current (short term) or long term. Current liabilities are due within one year. Long-term liabilities are due after one year.
Shareholders' equity is the amount owners invested in new stock plus the earnings the company retained since it started (Retained earnings is the amount of profit kept after dividends are paid). On the balance sheet the amount of shareholders' equity always equals the value of all the assets minus all the liabilities e.g. if a company's assets are valued at $100,000 and liabilities total $60,000, the equity is $40,000.
The shareholders’ equity section is made up of share capital and retained earnings. For a proprietorship or partnership, this section is referred to as owner’s equity and partner’s equity respectively. Owner’s equity consists of paid in capital and retained earnings. Paid in capital reflects the total amount of money paid by shareholders to purchase company stock (shares).
Unlike the Balance Sheet, which is a snapshot of the company’s financial position at a particular point in time, the ‘Income Statement’ (or ‘Profit and Loss Statement’) provides a picture of what has happened over a period of time e.g. a month, a quarter or a year. An typical Income Statement contains specific revenue and expense categories regardless of the nature of the business as described below:
- Gross Revenues (revenues from the sale of products and services)
- Less Cost of Goods Sold (cost of inventories)
- Equals Gross Margin (gross profit on sales before operating expenses)
- Less Operating Expenses (salaries, wages, payroll taxes and benefits, rent, utilities, maintenance expenses, office supplies, postage, automobile/vehicle expenses, insurance, legal and accounting expenses, depreciation)
- Equals Operating Profit (profit before other non-operating income or expense)
- Plus Other Income (income from discounts, investments, customer charge accounts)
- Less Other Expenses (interest expense)
- Equals Net Profit (or Loss) before Tax (the figure on which your tax is calculated)
- Less Income Taxes (if any are due)
- Equals Net Profit (or Loss) After Tax